DeFi 101: Decentralized Finance & How it Works
Discover the ins and outs of Decentralized Finance (DeFi) in our DeFi 101 guide. From beginner guides to advanced insights, explore our comprehensive directory. Here, we unravel the vast opportunities DeFi presents, its money-making strategies for crypto buffs, and other crucial aspects to consider.
What is DeFi?
Decentralized Finance, or DeFi, is transforming how people access and use financial services. Unlike traditional finance (also known as centralized finance, or CeFi), which relies on banks and other financial institutions to manage and control financial activities, DeFi removes these middlemen entirely. Instead, DeFi operates on blockchain networks using smart contracts—self-executing contracts with the terms directly written into code.
This shift is about more than just technology—it’s about creating a financial system that is open to everyone, operates around the clock, and allows individuals to control their own assets without needing permission from banks or governments. Let’s explore how DeFi works, its core components, and why it’s being seen as a potential game-changer in the financial world.
Read next: Best DeFi Portfolio Tools
How DeFi works
At its core, DeFi is built on blockchain technology, most commonly on Ethereum, although other networks like Solana, Avalanche, and Binance Smart Chain are also gaining traction. Instead of relying on institutions like banks or payment processors, DeFi relies on smart contracts to automate financial agreements.
A smart contract is essentially a piece of code that automatically executes an agreement once certain conditions are met. For example, if you put up collateral to borrow cryptocurrency, a smart contract can be programmed to automatically liquidate that collateral if its value drops below a certain threshold.
Key differences from traditional finance (CeFi)
No Intermediaries: Banks, brokers, and other institutions are removed from the process.
Open Access: Anyone with an internet connection and a crypto wallet can participate.
Automation: Transactions are processed automatically by code, not by people.
Transparency: All transactions are recorded on a public blockchain, which anyone can inspect.
DeFi shifts the foundation of financial trust away from human institutions and toward transparent, verifiable code.
Read next: Biggest DeFi Projects
Why DeFi matters
Traditional finance comes with a lot of barriers—high fees, slow processing times, and limited access for people without bank accounts or strong credit histories. DeFi aims to level the playing field by offering financial services to anyone, regardless of location or background.
Lower costs and faster transactions
Because DeFi eliminates intermediaries, transaction fees are generally lower. There’s no waiting for a bank to process a wire transfer or approve a loan—most DeFi transactions are settled within minutes (or even seconds).
Tokenization and new investment opportunities
DeFi allows real-world assets, like real estate and art, to be represented as blockchain-based tokens. This makes it possible to buy and sell fractions of assets that would normally be out of reach for most people. For example, you could own a small portion of a valuable painting or a commercial property through DeFi tokens.
Financial inclusion
Over a billion people globally don’t have access to traditional banking services. DeFi opens the door for these individuals to participate in financial markets, save, borrow, and invest without needing approval from a financial institution.
What are the benefits of DeFi
DeFi isn’t just about replacing banks—it offers some clear advantages over traditional finance:
1. Greater access
Anyone with an internet connection and a crypto wallet can access DeFi platforms.
No need for credit checks, proof of income, or approval from a bank.
2. Lower costs
Traditional financial institutions charge fees for transfers, loans, and investment products.
DeFi platforms, by removing intermediaries, drastically reduce these fees.
3. Transparency and security
All transactions are recorded on a blockchain, which is open for public inspection.
Users can verify the terms of any contract before participating.
4. Faster transactions
International bank transfers can take days to process.
DeFi transactions typically settle in minutes or even seconds.
5. Autonomy and control
With DeFi, users hold their own assets and private keys.
No centralized authority can freeze or seize funds.
6. Flexible investment options
DeFi allows users to earn interest, provide liquidity, and trade assets 24/7.
Tokenized assets make it possible to invest in real estate, commodities, and more without the typical barriers to entry.
7. Innovation for financial models
Flash loans (instant loans with no collateral if repaid within one transaction) open up new arbitrage and trading strategies.
Dynamic interest rates based on real-time supply and demand create efficient markets.
Read next: Best Decentralized Exchanges
What are the key components of DeFi
1. Stablecoins
Stablecoins are essential in DeFi because they provide a reliable medium of exchange and a unit of value in the volatile crypto market. Their value is typically pegged to a stable asset like the US dollar or a basket of currencies. Common types of stablecoins include:
Fiat-collateralized: Backed by cash or cash equivalents held in reserves (e.g., USDC, Tether).
Crypto-collateralized: Backed by other cryptocurrencies, often over-collateralized to protect against price swings (e.g., DAI).
Algorithmic: Use supply and demand algorithms to maintain a stable value without direct backing (e.g., the now-defunct UST).
Basket-collateralized: Pegged to a group of assets to reduce exposure to single-asset volatility (e.g., the initial model for Diem).
Read next: Stablecoins Guide
2. Decentralized exchanges (DEXs)
A decentralized exchange allows users to trade cryptocurrencies directly with one another without needing a central authority. Most DEXs rely on Automated Market Makers (AMMs). Some of the most popular dexes include:
Uniswap: Uses liquidity pools to enable fast, decentralized trading.
SushiSwap: A fork of Uniswap that includes governance tokens.
Balancer: Allows multi-token pools, acting as both an AMM and a portfolio manager.
3. Lending and borrowing platforms
DeFi lending platforms let users lend their crypto assets to others or borrow against their holdings without involving a bank. Some notable DeFi lending platforms include:
Aave: Introduced flash loans and flexible interest rates.
Compound: Allows lenders to earn interest through cTokens and COMP tokens.
What are the challenges and risks of DeFi?
1. Smart contract vulnerabilities
Smart contracts are written in code, which means they can have bugs. If a flaw is exploited, funds can be drained from the platform.
2. Centralization concerns
Not all DeFi platforms are fully decentralized. Some platforms maintain admin keys or rely on centralized infrastructure, which creates potential points of failure.
3. Market and systemic risks
Liquidity crises can occur if many users withdraw funds at once.
Flash loan attacks (where large loans are used to manipulate prices) remain a problem.
Highly interconnected platforms can trigger cascading failures if one major platform is attacked or compromised.
4. Regulation and compliance
Governments are still figuring out how to regulate DeFi. Compliance with anti-money laundering (AML) and know-your-customer (KYC) rules remains a gray area. Platforms operating outside regulations could face penalties or shutdowns.
Read next: Crypto Scams
What's the future of DeFi?
Decentralized autonomous organizations (DAOs)
DAOs are collective governance structures where token holders vote on decisions related to the platform. This allows for truly decentralized management of financial platforms.
Cross-chain interoperability
Currently, most DeFi activity is limited to individual blockchains. Cross-chain solutions (like Polkadot and Cosmos) aim to allow assets and data to flow across different blockchains, improving liquidity and creating more seamless trading opportunities.
Real-world asset integration
Real estate, commodities, and even intellectual property are starting to be represented as tokens on blockchain networks. This could open up access to traditionally exclusive markets and provide liquidity for previously illiquid assets.
Overall, DeFi represents more than just a technological shift—it’s a reimagining of how financial systems can work. By cutting out intermediaries, automating financial services with smart contracts, and ensuring transparency through blockchain technology, DeFi creates a more open and accessible financial system.
That said, DeFi isn’t without its challenges. Security vulnerabilities, market manipulation, and regulatory uncertainty could slow its growth or lead to setbacks. However, with ongoing development in areas like DAOs, cross-chain interoperability, and real-world asset tokenization, DeFi's potential to reshape global finance remains significant.
Don't forget the tax bill...
Even though most tax offices are yet to catch up with DeFi, your DeFi transactions may come with a tax bill. You can learn more in our dedicated DeFi tax guides, including:
